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The outlook for US government debt

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THE bond market used to be the prime exhibit for those predicting low long-term economic growth. In the summer of 2016 the ten-year Treasury yield briefly dipped below 1.5%, as expectations for growth and inflation sagged. Things have changed. Earlier this year the ten-year yield briefly went higher than 2.9%. Even after recent share-price gyrations, it remains around 2.8%, well up since the start of 2018. The rebounding interest rate partly reflects higher confidence in global growth. Inevitably, a new set of pessimists now voice a fresh worry: that bond yields might go on rising for less welcome reasons.

They point to three threats. The first is monetary policy. The Federal Reserve has raised short-term interest rates by 1.5 percentage points since December 2015. At their March meeting, rate-setters slightly upgraded forecasts of how far rates should eventually rise. Last October the Fed began shrinking its $4.5trn portfolio of assets, mostly government debt, amassed since the start of the financial crisis. Quantitative easing (QE) supposedly worked by depressing long-term interest rates. Unwinding it could push them back up.

American policymakers are not the only ones tightening. Britain raised interest rates in November, and many investors expect the European Central Bank to end its QE programme this year. Economists increasingly think the “term premium”—the reward investors demand for locking their money away—is determined globally. The expectation of tighter money abroad could push American rates up, too.

The second threat is fiscal policy. President Donald Trump’s tax cuts, which are expected to cost around $1trn over a decade, have deepened the hole in America’s public finances. A budget deal in March raises annual spending by at least $143bn (0.7% of GDP). Pension and health-care costs are rising. On April 9th official budget-watchers projected deficits greater than 4% of GDP every year for the next decade. Primary dealers—middlemen between governments and investors in the public-debt market—expect almost $1trn of net issuance of new debt in the 12 months to September 2018.

The third threat comes from abroad. China and America have engaged in several rounds of setting or threatening tit-for-tat tariffs on each other’s exports. If a trade war erupts, one way China could retaliate might be to reduce its holdings of Treasuries, currently about $1.2trn.

So there is much to worry the bond bears. But all three threats are somewhat overblown. Start with China. If it dumped dollar assets, it would push down the greenback, boosting American exports. That would be a strange move in a trade war. It has been reported that China could do the opposite—boost its exports by devaluing the yuan—though this too is improbable. A big devaluation would damage China’s authority around the world, and might trigger another round of capital outflows. The Chinese government has fought hard to stop these over the past two years.

The Fed, meanwhile, signalled its plans to shrink its balance-sheet well in advance, so the effects of reversing QE should mostly be priced in. And the loose consensus among economists is that asset purchases brought down the ten-year yield by only about a percentage point. Not all think the effect on the way out will be as large.

As for fiscal laxity, net new borrowing of nearly $1trn is relatively small compared with the gross amount of debt America regularly rolls over. (In the year to February, the Treasury issued securities worth over $9trn.) That interest rates remain low despite plentiful public borrowing indicates that safe assets are still in demand. Thank structural shifts in the world economy, such as rising life expectancy that causes more saving for retirement.

America faces a big challenge balancing its books in the long term. If it does not, interest rates must soar eventually. But countries usually have fiscal wriggle-room as long as they grow, in nominal terms, at a rate higher than the interest on their debt. America remains well within this comfort zone. Rates may rise a little more, but that would give the Fed welcome room to loosen policy the next time recession strikes. Pessimists who thought rates would never rise were wrong. Today’s bond-market doomsayers probably are, too.

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Japan still has great influence on global financial markets

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IT IS the summer of 1979 and Harry “Rabbit” Angstrom, the everyman-hero of John Updike’s series of novels, is running a car showroom in Brewer, Pennsylvania. There is a pervasive mood of decline. Local textile mills have closed. Gas prices are soaring. No one wants the traded-in, Detroit-made cars clogging the lot. Yet Rabbit is serene. His is a Toyota franchise. So his cars have the best mileage and lowest servicing costs. When you buy one, he tells his customers, you are turning your dollars into yen.

“Rabbit is Rich” evokes the time when America was first unnerved by the rise of a rival economic power. Japan had taken leadership from America in a succession of industries, including textiles, consumer electronics and steel. It was threatening to topple the car industry, too. Today Japan’s economic position is much reduced. It has lost its place as the world’s second-largest economy (and primary target of American trade hawks) to China. Yet in one regard, its sway still holds.

This week the board of the Bank of Japan (BoJ) voted to leave its monetary policy broadly unchanged. But leading up to its policy meeting, rumours that it might make a substantial change caused a few jitters in global bond markets. The anxiety was justified. A sudden change of tack by the BoJ would be felt far beyond Japan’s shores.

One reason is that Japan’s influence on global asset markets has kept growing as decades of the country’s surplus savings have piled up. Japan’s net foreign assets—what its residents own abroad minus what they owe to foreigners—have risen to around $3trn, or 60% of the country’s annual GDP (see top chart).

But it is also a consequence of very loose monetary policy. The BoJ has deployed an arsenal of special measures to battle Japan’s persistently low inflation. Its benchmark interest rate is negative (-0.1%). It is committed to purchasing ¥80trn ($715bn) of government bonds each year with the aim of keeping Japan’s ten-year bond yield around zero. And it is buying baskets of Japan’s leading stocks to the tune of ¥6trn a year.

Tokyo storm warning

These measures, once unorthodox but now familiar, have pushed Japan’s banks, insurance firms and ordinary savers into buying foreign stocks and bonds that offer better returns than they can get at home. Indeed, Japanese investors have loaded up on short-term foreign debt to enable them to buy even more. Holdings of foreign assets in Japan rose from 111% of GDP in 2010 to 185% in 2017 (see bottom chart). The impact of capital outflows is evident in currency markets. The yen is cheap. On The Economist’s Big Mac index, a gauge based on burger prices, it is the most undervalued of any major currency.

Investors from Japan have also kept a lid on bond yields in the rich world. They own almost a tenth of the sovereign bonds issued by France, for instance, and more than 15% of those issued by Australia and Sweden, according to analysts at J.P. Morgan. Japanese insurance companies own lots of corporate bonds in America, although this year the rising cost of hedging dollars has caused a switch into European corporate bonds. The value of Japan’s holdings of foreign equities has tripled since 2012. They now make up almost a fifth of its overseas assets.

What happens in Japan thus matters a great deal to an array of global asset prices. A meaningful shift in monetary policy would probably have a dramatic effect. It is not natural for Japan to be the cheapest place to buy a Big Mac, a latté or an iPad, says Kit Juckes of Société Générale. The yen would surge. A retreat from special measures by the BoJ would be a signal that the era of quantitative easing was truly ending. Broader market turbulence would be likely. Yet a corollary is that as long as the BoJ maintains its current policies—and it seems minded to do so for a while—it will continue to be a prop to global asset prices.

Rabbit’s sales patter seemed to have a similar foundation. Anyone sceptical of his mileage figures would be referred to the April issue of Consumer Reports. Yet one part of his spiel proved suspect. The dollar, which he thought was decaying in 1979, was actually about to revive. This recovery owed a lot to a big increase in interest rates by the Federal Reserve. It was also, in part, made in Japan. In 1980 Japan liberalised its capital account. Its investors began selling yen to buy dollars. The shopping spree for foreign assets that started then has yet to cease.

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